Living Economics

Price must cover cost for business survival but its level above cost varies with the product life cycle.

Before the eBay online auction site was available, it was difficult to find out how much an old baseball card is worth. There may not be a market for it as it is expensive to get the sellers and buyers together. With enough buyers and sellers, the competitive bidding process will set the spot price. Given the number of sellers and the number of cards offered, the more buyers are bidding, the higher the resulting price would be. Similarly, given the number of sellers and buyers, the more cards are offered, the lower the resulting price would be. The balance between offers and bids will determine where the price would eventually settle.

Once some prices are determined, prices of similar and related goods can be tentatively set without going through the competitive bidding process. To start with, most goods are reproducible on an ongoing basis with known costs. So prices have to be high enough to cover costs with a profit margin. But how high can the profit margin be?

If a good is unique with few substitutes, the profit margin can be higher. For a “commodity” good with many sellers, the profit margin would barely cover production costs. That is why firms keep coming up with new and improved versions of existing goods. Better still, they want to offer innovative products with no close substitutes. If the good delivers higher-quality service than an existing good, then it can command a price premium. For example, some new prescription drugs can replace expensive surgical procedures. They are often priced high enough to capture the potential cost savings resulting from replacing the expensive surgical procedures with the new drugs regardless of the drugs’ development and production costs.

The market does not, however, guarantee that prices would always cover production costs. If the firm misjudges the market demand for its products, prices might have to be lowered to below production costs just to dispose of the existing stocks.

Prices tend to fall over the product life cycle as the market is saturated. As a new product appears, it is generally priced higher to attract the first adopters who value the product more than other consumers. To grow the market, prices must then be lowered to attract consumers who have lower value for the product. As the market is saturated and substitute products are made available, the product is commoditized and price is lowered to just covering production costs.

When one low price is charged to all consumers (single pricing), those who still value the product more than others would reap consumer surplus by paying less than the maximum price (reservation price) they would have been willing to pay rather than doing without.

If perfect price discrimination were possible, each buyer could be charged his/her reservation price leaving no consumer surplus. But buyers with lower reservation prices could still afford the good in question whereas they would be completely shut out under single pricing if the single price were above their reservation prices. Successful price discrimination is possible only when goods purchased at lower prices cannot be easily re-sold at higher prices.